Read on Twitter
Credit Default Swaps (CDS).
Lots of attention on US Sov CDS given the debt ceiling. 1Y has traded higher than in the 2011 episode.
CDS at the best of times is a bad market. DM sov CDS is even worse.
1/
Lots of attention on US Sov CDS given the debt ceiling. 1Y has traded higher than in the 2011 episode.
CDS at the best of times is a bad market. DM sov CDS is even worse.
1/
2/ Debt ceiling deadlines have heavily distorted the extreme front-end of the Treasury curve.
This is entirely a resulted of the predicted d-day for the Treasury. nothing more.
No-risk cash doesn't want to deal with risk.
@dampedspring has covered this well.
This is entirely a resulted of the predicted d-day for the Treasury. nothing more.
No-risk cash doesn't want to deal with risk.
@dampedspring has covered this well.
3/ This has heavily inverted the curve for US Sov CDS spreads, with immediate maturities pricing in more risk.
If this was a corporate you would say 1Y CDS at 130bp implies a 2.6% chance of default within the year with 50% recovery on capital.
But it obviously isn't a corp.
If this was a corporate you would say 1Y CDS at 130bp implies a 2.6% chance of default within the year with 50% recovery on capital.
But it obviously isn't a corp.
4/ This is where problems start.
I'm not a big fan of CDS in general. It has so many bad characteristics. DM sov CDS amplifies these.
CDS was created to have a use (hedging physical bonds), but it doesn't do that job particularly well. So it becomes a degen trading contract.
I'm not a big fan of CDS in general. It has so many bad characteristics. DM sov CDS amplifies these.
CDS was created to have a use (hedging physical bonds), but it doesn't do that job particularly well. So it becomes a degen trading contract.
5/ Here are the contract details for US sov.
Note that the currency is "EUR" and not "USD".
Why? Because of this thing called "quanto" risk.
Note that the currency is "EUR" and not "USD".
Why? Because of this thing called "quanto" risk.
6/ "Quanto" risk is the conditional correlated risk between the default of the name on the CDS, and the currency of the contract.
This was a big problem with CDS on banks in the GFC.
If your banking system died, your ccy would probably go with it. This risk is hard to price.
This was a big problem with CDS on banks in the GFC.
If your banking system died, your ccy would probably go with it. This risk is hard to price.
7/ If this was a problem for banks, you could imagine what it would be like with a sovereign. Therefore the US sov CDS is priced in EUR.
But hold on, the US doesn't issue bonds in EUR. So how does a default get settled?
But hold on, the US doesn't issue bonds in EUR. So how does a default get settled?
8/ This brings me to the real problem with CDS.
The default event process is not determined by the market, but by a bunch of lawyers at ISDA.
Once they agree that a default has occurred, people can submit bonds into an auction and a settlement price is reached.
The default event process is not determined by the market, but by a bunch of lawyers at ISDA.
Once they agree that a default has occurred, people can submit bonds into an auction and a settlement price is reached.
9/ The event of default process has created some bizarre situations in the past.
One of my favourite was the restructure of debt by Cemex (a Mexican cement company) after buying Rinker in 2007.
The ISDA board couldn't decide if it was an event and didn't trade for 2 months.
One of my favourite was the restructure of debt by Cemex (a Mexican cement company) after buying Rinker in 2007.
The ISDA board couldn't decide if it was an event and didn't trade for 2 months.
10/ This paper covers the CDS market well if you want to know more.
It highlights the size of sov CDS as a market. Note that most of that 14% is emerging markets, and not DM.
federalreserve.gov/econres/feds/f…
It highlights the size of sov CDS as a market. Note that most of that 14% is emerging markets, and not DM.
federalreserve.gov/econres/feds/f…
11/ This point highlights where sov CDS isn't totally useless.
Turkish or Brazilian CDS denominated in USD provides a useful hedging instrument when a large portion of that debt is issued in USD.
Event of default determinations will still be problematic, but at least it works.
Turkish or Brazilian CDS denominated in USD provides a useful hedging instrument when a large portion of that debt is issued in USD.
Event of default determinations will still be problematic, but at least it works.
12/ For a DM sov CDS like the US, none of these things are true.
You might be thinking then...why not just sell US CDS and collect the premium in normal times?
Well then you run into the costs of balance sheet and collateralisation. Earning 10bp for that?
You might be thinking then...why not just sell US CDS and collect the premium in normal times?
Well then you run into the costs of balance sheet and collateralisation. Earning 10bp for that?
13/ For these reasons, the spread on US CDS bears little relationship to implied default probabilities.
For a corporate (non-bank) and EM sov, you can do this.
For US CDS, it's just a illiquid measure of sentiment, with no real world use and implication.
For a corporate (non-bank) and EM sov, you can do this.
For US CDS, it's just a illiquid measure of sentiment, with no real world use and implication.
• • •
Missing some Tweet in this thread? You can try to
force a refresh
